Believe those who are seeking the truth. Doubt those who find it.Andre Gide

Tuesday, September 22, 2009

Kocherlakota on the State of Macro

A very nice piece by NK here. Unfortunately, you won't see something like this published in the NYT. But naturally, we can rely on DeLong to make a comment; see here: Narayana Leaves Me Puzzled. Consider this DeLong quote:

The models thus tell us that downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.

This is exactly how I would expect a first-year undergraduate to interpret a model that they've seen for the first time. And DeLong claims that he has a PhD in economics. Let me help the poor lad along.

Some macro models incorporate "news shocks." A news shock is the random arrival of information that leads people to (rationally) revise their forecasts of future events. These forecasts may be made, for example, over future productivity, future riskiness of investments, future policies, etc. These news shocks do not seem like an implausible impulse mechanism; unexpected news arrives every day.

Investment demand today depends on forecasted productivity of investment. These forecasts will change with news; leading to variations in investment that an econometrician might identify as "aggregate demand shocks." As the investment matures and comes online, its actual productivity may be higher or lower than originally forecast; its realization constitutes another "shock."

There is no need to appeal to DeLong's childish "great forgetting" interpretation of a negative technology shock. A negative technology shock occurs when the realized return on investment is lower than expected. The return on an important class of investments may turn out to be terrible (think of all the fibre optic cable planted across the world's oceans in anticipation of a demand that never materialized). And as Fisher Black has stressed, these types of errors are typically correlated across agents. In short, recessions may be explained, in part, by collective mistakes on investments made in the past.

In any case, what DeLong fails to offer us what he might propose instead as the ultimate source of the business cycle? I am guessing that he might say something like "animal spirits." So why did the recession occur? Because people thought that it would. Why did that boom occur? Because people believed that it would.

There may be an element of truth to the animal spirit hypothesis; but then, there do appear to be competing interpretations as well. If DeLong would spend less time writing his blog and more time reading the literature, he might one day be less puzzled with Narayana's observations.

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"Believe those who are seeking the truth. Doubt those who find it." Andre Gide

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